Inflation is soaring, and the Federal Reserve is midway through an entire year of interest rate increases to combat it. The average 30-year mortgage rate is already up over 2% this year, from 3.24% to 5.28%.
When interest rates go up, real estate prices tend to go down. It's a basic reality of supply and demand. When it costs more to borrow money, real estate buyers can't afford to bid up prices as much. Eventually, many buyers are pushed out of the market altogether, and supply overtakes demand, causing prices to fall.
But what does that mean for your portfolio? In the short run, it means pain. But that could all be paper losses if you stay patient and focus on the long run.
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1. Not much in the long term
As long as you have a good long-term loan and a low loan-to-value ratio (LTV), short-term drops in real estate prices may increase your blood pressure, but they don't really matter in the long term.
Let's say you bought a residence with a 30-year mortgage eight years ago and have since moved and now rent it out. Your LTV is 60%, and your rate is fixed for the next 22 years. If the property's market price falls, it shouldn't change anything for you. Rents tend to stay consistent even in real estate bear markets (all those buyers who were constrained from buying have to rent), and you're not trying to sell the house.
At the Motley Fool, we're fond of talking about how short-term losses aren't real losses until you sell the stock. If you stick with it, the investment may eventually turn around. The same is true for real estate investments.
If you don't have a friendly debt situation (such as adjustable-rate, high LTV, or short-term), you may be in for some drama. Banks start to get nervous when your LTV goes up and your loan may be downgraded. If you're up for a renewal and your collateral value tanks, it could be far harder to get a new loan. Not to mention that it's possible that by the time you need to renew the loan, the rates could be double what they were when the loan was initiated.
If this is the case, buckle down and do what you can to make it work. If you need to bring in more equity or shop around for a new lender with lower rates, do it. It's likely that you'll be able to refinance again in the future and get a better deal. The key is to stick with the investment long term. Let the tenant make the debt payments and help build your wealth.
2. Some of your real estate investments may be immune
If you've beefed up your commercial or residential real estate portfolio with REITs, or real estate investment trusts, you could have some level of immunity to interest rates. REITs buy and manage real estate on a far greater level than individual investors and have more resources to hedge interest rate risk.
A good example is mortgage REITs, which make or purchase real estate loans with borrowed money. They often match short-term financing with long-term purchases. This can spell trouble when interest rates go up and their short-term notes need to be renewed with interest rates that are now higher than their long-term investments yield.
Management at many mortgage REITs has adjusted their strategy in the past five or 10 years as interest rate fears have ramped up. Some REITs have hedging programs that pay off when interest rates go up. Some invest in adjustable-rate mortgages so that their revenues will increase along with rates. And some focus on short-term investments.
If you do own REITs, take some time to figure out what the management team's plan is for dealing with rising rates. Do they have a hedging program or some other strategy? If you're not satisfied, consider swapping the investment out for a new REIT.
3. Your other investments will get hit too
When interest rates go up, the stock market tends to fall as well. Businesses have a harder time getting financing for new projects and growth. Investors start to allocate cash to fixed-income investments that now have higher yields. And the easy-money spigot that was flowing straight into the stock market gets shut off.
Unfortunately, all that means you probably won't be able to take refuge in your stock portfolio if your real estate portfolio is crashing. Of course, if you take the long-term view we've discussed, you'll still be fine in the long run. Keep a good amount of dry powder (cash) ready for opportunities, and take them when the market falls. But don't sell out of your investments unless the thesis has really changed and the business model is no longer viable.
Remember: You'll be fine in the long run
Investors waste a lot of time and anxiety on future potential crashes. And if your investments are over leveraged or otherwise in a bad position, you probably do need to set aside some reserves. Otherwise, your best bet is to keep investing. As Warren Buffett is fond of saying, "Be fearful when others are greedy, and greedy when others are fearful." In other words: Buy when there's blood in the streets.
